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INVESTMENT ANALYSIS
FIN 4426
CHAPTER 1
THE INVESTMENT SETTING
Learning Outcomes:
After reading this chapter, students should be
able to answer the following questions:
Why do individuals invest?
What is an investment?
How do investors measure the rate of return
on an investment?
How do investors measure the risk related to
alternative investments?
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Learning Outcomes:
What factors contribute to the rates of return
that investors require on alternative
investments?
What macroeconomic and microeconomic
factors contribute to changes in the required
rates of return for investments?
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What Is An Investment?
Definition: A current commitment of money
for a period of time in order to derive future
payments that will compensate for:
The time the funds are committed
The expected rate of inflation
Uncertainty of future flow of funds
Reason for Investing: By investing (saving
money now instead of spending it), individuals
can tradeoff present consumption for a larger
future consumption.
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What Is An Investment?
Pure Rate of Interest
It is the exchange rate between future consumption
(future dollars)
and present consumption (current
dollars).
Market forces determine this rate.
Example: If you can exchange $100 today for $104
next year, this rate is 4% (104/100)1.
Pure
Time
Value of Money
The fact that people are willing to pay more for the
money borrowed and lenders desire to receive a
surplus on their savings (money invested) gives rise
to the value of time referred to as the pure time
value of money.
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What Is An Investment?
Other Factors Affecting Investment Value
Inflation
: If the future payment will be diminished
in value because of inflation, then the investor will
demand an interest rate higher than the pure time
value of money to also cover the expected inflation
expense.
Uncertainty
: If the future payment from the
investment is not certain, the investor will demand
an interest rate that exceeds the pure time value of
money plus the inflation rate to provide a risk
premium to cover the investment risk Pure Time
Value of Money.
*Risk premium: the additional return added to the nominal, riskfree interest rate
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What Is An Investment?
The Notion of Required Rate of Return
The minimum rate of return an
investor require
on
an investment, including the pure rate of interest
and all other risk premiums to compensate the
investor for taking the investment risk.
Investors may expect to receive a rate of return
different from the required rate of return, which is
called
expected rate of return
.
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Historical Rates of Return
Return over a Holding Period
Holding Period Return (HPR)
answer in decimal point
can not be a negative value
Holding Period Yield (HPY)
HPY=HPR1
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Investment
of
Value
Beginning
Investment
of
Value
Ending
HPR
=
Annual HPR and HPY
Annual HPR
= HPR
1/n
Annual HPY
= Annual HPR 1
= HPR
1/n
– 1
where n=number of years of the investment
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 Spring '09
 DON'TKNOW
 Finance, Capital Asset Pricing Model, Interest, Risk in finance

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